Accounting conventions and their effects on financial position

Balance Sheets

This report can also be referred to as “The Statement of Financial Position” (Atrill & McLaney, 2008). It shows a “snapshot” of the businesses financial position, it is important to remember that the balance sheet only reflects for the date on which it was prepared; it is not highly unlikely that dates before and after may be significantly different. The details on the Balance sheet include a value listing of the current assets (items equitable to a monetary value with an expected conversion to the proposed value within 12 months), the non-current assets (the same as current but with an expected conversion to monetary value that is over 12 months), versus the liabilities (items that the business owes money on, such as loans and stock purchased on credit; both current and non-current) and equities (amounts paid in to the business by the owners as well as the profits generated by the business).

As the name states, the balance sheet should always balance so that the Total Assets = Total Equity + Total Liabilities.

Accounting Conventions – Effects on Measuring & Reporting Financial Position

There are a number of different accounting conventions that can change the appearance of a company’s financial position which are outlined by Atrill & McLaney (2008) and can be summarised as follows:

  • Business Entity Convention:
    Whether a business is a sole proprietorship or a partnership, or any other kind of business, the business always exists as its own entity with its own finances. If the business owner invested $ 50 000 in to the business then that is considered as an amount the business “owes” the owner.
  • Historic Cost Convention:
    This convention specifies that the costs of assets are to be recorded and maintain the original cost value throughout their lifetime. The purchase of a vehicle which depreciates fairly rapidly and the cost of property which appreciates will be recorded at the original purchase price. In these two situations the financial representation can be biased either positively or negatively respectively.
  • Prudence Convention:
    This convention is used to avoid over-optimistic projections by managers and directors. All possible losses are recorded once and in full while the profits are only recorded once they actually happen. This is a somewhat bleak outlook on financial position and may end with investors placing a lower value on their investments into the business than the true value.
  • Going Concern Convention:
    This convention has a more positive view than the prior convention. The assumption is made that the business will not be closing in the foreseeable future. Values are taken as current. The issue that arises with this convention that is if the company is to close, assets being sold off will more than likely be sold for less than their reflected value.
  • Dual Aspect Convention:
    This convention keeps with the concept of the balance sheet. Each transaction has a positive and negative effect on the balance sheet and should be recorded as so in the relevant categories. This assures the balance sheet will always balance.

Asset Valuation – Effects on Measuring & Reporting Financial Position

Asset valuation can be measured in different ways. One of the ways as mentioned above is the historic cost method where an asset is valued at its original cost to the business. As with the example above, it is important to keep an accurate record of the depreciation (decrease in value, such as with motor vehicles) and/or appreciation (increase in value, such as with property) recorded to maintain a more accurate measurement of the true values.

“Fair values” may also be used to measure an assets worth. This can be the assessed value of replacing or selling the asset as opposed to the depreciated or appreciated value of the asset. Fair value is often open to much debate and is more difficult to pin-point than appreciated or depreciated values.

References

Atrill, P. & McLaney, E. (2008) Accounting and Finance for Non-Specialists. 6th Edition. Financial Times Press.